Complexity, Compliance, and Communication

1. Complexity, Compliance, and Communication Why Should Taxpayers Comply in a Complex and Changing Tax Environment? Nina E. Olson National Taxpayer Advocate Presentation to the President’s Advisory Panel on Federal Tax Reform March 3, 2005

2. TY 2002 Taxpayer Characteristics Note: The “mean” is the average (that is, the sum of numbers on a list divided by the number of numbers on the list). The “median” is the midpoint of numbers on a list (that is, half of the numbers are less than the median and half are greater than the median). 2

3. TY 2002 Taxpayer Characteristics 3

4. Projections for 2010 • Married couples with children = 22% of households, down from 31% in 1980. • Taxpayers living alone, non-relatives living together, and families of non-married relatives = 49.6%, up from 39.1% in 1980. • U.S. foreign-born and immigrant population = 11.3% (34 million), up from 10.4% (28.4 million) in 2000. • 51% of the foreign born will be from Latin America, 26% from Asia. 13% will speak Spanish in their homes. 4

5. Projections for 2010 • Households without children under 18 and non-family households will rely primarily on conventional methods of contact (non-Internet). This population includes elderly with restricted income or mobility. • Internet use will be lowest among people (1) over 50; (2) with incomes below $35,000; (3) with high school or lower education levels; and (4) in non-family households. • 157.7 million people will be in the workforce, up from 141 million in 2000. • People age 55 and older = 17% of the labor force, compared to 13% in 2000. 5

6. Areas of Significant Complexity • Family Status Provisions – dependents, filing status, child tax credit, dependent care credit. • Electronic Commerce. • Joint and Several Liability (including community property). • Mortgage Interest Rules. • Earned Income Tax Credit (EITC). • Alternative Minimum Tax (AMT). • Retirement Provisions. • Education Provisions. • “Kiddie” Tax. • Worker Classification. 6

7. Complexity - EITC • Provision contains 2,680 words and 13 subsections. • Requires at least a twelfth-grade education to understand. • EITC Information Package (IRS Pub. 596) contains 53 pages of forms, instructions and worksheets. • In TY 2003, 71.5% of EITC claimants used a paid preparer. • The EITC overclaim rate is estimated to be 27% - $8.5 billion of the estimated $31.3 billion in 1999 EITC claims. 7

8. Complexity - AMT • Penalizes taxpayers for such “classic tax avoidance behavior" as having children or living in a high-tax state. • In 2004, average AMT taxpayer is projected to owe additional $6,000 in AMT (TPC estimate). • Complexity impacts many more taxpayers than those who owe the AMT. • To determine whether AMT liability exists, taxpayers must complete 12-line worksheet, read 8 pages of instructions, and complete 55-line form. • Adds insult to injury by subjecting many taxpayers to penalties. 8

9. Complexity – AMT Example • Mr. & Mrs. Brady live in California in a rented home with their six children ages 5 - 16. They claim the “married filing jointly” filing status and take the $9,700 standard deduction for 2004. • Mr. Brady, an architect, made $73,160. Mrs. Brady worked part time as a teacher and earned $25,000. The Bradys owe $3,394 in taxes – before considering the AMT. • Mr. & Mrs. Brady’s tax bill rises to $4,442 with the AMT. 9

10. Complexity - Retirement • More than a dozen tax-advantaged retirement planning vehicles in the Code. • Proliferation of plans and rules cause confusion and may reduce participation. • Need for uniformity • Hardship exception for early withdrawals. • Availability of plan loans. • Ability to roll over into other plans (portability). see Retirement Table – Appendix 10

11. Complexity - Education • At least 9 separate education credits, deductions and income exclusions. • There are 4 different measures of income, 6 different income threshold amounts, and 3 different definitions of “Qualified Higher Education” expenses. • Education Information Package (IRS Pub. 970) contains 83 pages of text, flowcharts and worksheets. • In 2002, approximately 6.5 million individual taxpayers claimed education tax credits totaling approximately $4.9 billion. 11 see Education Tables – Appendix

12. Compliance Rates 12

13. Compliance Factors • Withholding and 3rd Party Reporting are compliance facilitators. • The cash economy is subject to little or no tax withholding or 3rd party income reporting. • It is estimated that two-thirds of the gross tax gap is attributable to self-employed taxpayers. • This amount includes the “cash economy” – that is, sources of income that are not reported to the IRS. 13

14. What makes Taxpayers Noncompliant • Drivers of noncompliance include: • Complexity • Programmatic and procedural flaws. • Taxpayer attitudes toward compliance fall into three basic categories: • Will comply • Trying to comply • Won’t comply. 14

15. Deterrents to Non-Compliance The strongest factor influencing tax reporting is Personal Integrity 15 Source: Roper ASW, 2003 IRS Oversight Board Compliance Study Report (Sept. 2003), pp. 10-11.

16. Procedural Administrative complexity Lazy Unwilling or unable to satisfy requirements Unknowing Confusion about the rules Asocial Classic tax cheating Brokered Advice of tax professionals Symbolic Perceived inequities in the tax laws or tax administration Social Social or economic circumstance Habitual History of non-compliance emboldened by “getting away with it” Types of Non-Compliance 16

17. Communication • How do we “touch” taxpayers? • Pre-Filing • Filing • Post-Filing • How does the “touch” affect compliance? • Do we convert a taxpayer from “trying to pay” to “won’t pay” if we make the wrong type of “touch”? • Taxpayers consider IRS-provided information valuable. • People prefer phone or face-to-face contact. • Procedures and forms should be evaluated and tested prior to implementation. 17

18. Compliance • Why should taxpayers comply? • Social Norm • Social Contract/Agreement with Taxpayers 18

19. Tax Reform Considerations Design a system that - • Does not “entrap” taxpayers. • For the majority of Americans, can be complied with on a single form and document matched. • Allows most individual and small business taxpayers to fill out their own returns. • Tax administrators can explain. • Anticipates the largest areas of non-compliance. • Does not create whole armies of industries. • Provides choice – but, not too many options. 19

20. Tax Reform Considerations • Refundable credits are not inherently problematic – it’s all in the design. • System should incorporate periodic review of the Code – in short, a sanity check. 20

21. Appendix 21

22. TY 2002 Taxpayer Characteristics 22

23. Complexity - EITC • For TY 2002, approximately 21.7 million taxpayers filed approximately $38.2 billion in EITC claims. • IRC § 32 contains 2,680 words (it has a Flesch reading ease of 31.3% and a Flesch-Kincaid grade level of 12.0). • IRC § 32 contains 13 subsections [(a) through (m)]. • Publication 596, Earned Income Credit (EIC), contains 53 pages of forms, instructions and worksheets. • For TY 2003, 71.5% of EITC claimants used a paid preparer. • The EITC overclaim rate is estimated to be 27% - $8.5 billion of the estimated $31.3 billion in 1999 EITC claims were overclaims. • The EITC examination rate was 1.65% in FY 2002. • The IRS issued 1,083,090 math error notices in FY 2002. 23

24. Complexity - AMT • Hits taxpayers it was never intended to hit. • Catches taxpayers by surprise. • Adds insult to injury by subjecting many taxpayers to penalties. • Add-on tax was enacted after Treasury reported that 155 taxpayers with AGI above $200,000 in 1966 paid no tax; gave taxpayers $30,000 exemption.  If indexed, those figures would be $1.16 million and $153,500 today. • Penalizes taxpayers for such “classic tax avoidance behavior" as having children or living in a high-tax state. • In 2004, average AMT taxpayer is projected to owe additional $6,000 in AMT (TPC 2004 estimate). • To determine whether AMT liability exists, taxpayers must complete 12-line worksheet, read 8 pages of instructions, and complete 55-line form. • In 2010, AMT is projected to hit 34.8 million taxpayers (Treasury estimate), including 94% of married couples with AGI between $75,000 and $100,000 who have two or more children (TPC 2004 estimate). 24

25. Complexity - Retirement • More than a dozen tax-advantaged retirement planning vehicles in the Code. • Proliferation of plans and rules cause confusion and may reduce participation. • Need for uniformity • Hardship exception for early withdrawals. • Availability of plan loans. • Ability to roll over into other plans (portability). 25

27. Complexity - Education • There are at least nine education provisions in the Code in the form of credits, deductions and income exclusions. • IRS Publication 970, Tax Benefits for Education, contains 83 pages of text, flowcharts and worksheets. • Among the education provisions, there are four different measures of income and six different income threshold amounts for qualification purposes. • There are three different definitions of “Qualified Higher Education” expenses. • In tax year 2002, approximately 6.5 million individual taxpayers filed income tax returns reporting education tax credits totaling approximately $4.9 billion. • Between October 1, 2003 and August 31, 2004, W&I started 1,713 audits, closed 1,887 audits, and assessed approximately $1.2 million on audits related to IRC § 25A education tax credit . 27

28. [1] IRC § 25A(d); IRS Publication 970, Tax Benefits for Education for use in preparing 2004 Returns, Catalog No. 25221V, 14, 22. [2] IRC §§ 25A(b)(1), (c)(1). [3] IRC § 25A(b)(4). [4] IRC § 25A(c)(1). [5] IRC § 25A(h). [6] IRC § 25A(d). [7] IRC § 25A(f)(1)(A). [8] IRC § 25A(b)(2). Furthermore, the student will not be eligible if convicted of a felony drug charge. IRC § 25A(b)(2)(D). [9] IRC § 25A(f)(1). [10] IRC § 25A(f)(2).

29. [1] IRC § 117(b)(1). [2] IRC § 117(b)(2). [3] IRC § 117(a).

30. [1] IRC § 127(a). [2] IRC § 127(a)(1). [3] IRC § 127(C)(1). [4] IRC § 127(b).

31. [1] IRC § 135(b)(2)(B). [2] IRC § 135(b)(2)(C). [3] IRC § 135(b)(2). [4] IRC § 135(c)(2)(A). [5] IRC § 135(c)(2). [6] IRC § 135(c)(3).

32. [1] IRC § 221(b)(2)(B)(i)(II). [2] IRC § 221(b)(1). [3] IRC § 221(f). [4] IRC § 221(b)(2)(B). [5] IRC § 221(d)(1)(A). [6] IRC § 221(d)(2). [7] IRC § 221(d)(2).

33. [1] IRC § 222(b)(2). [2] IRC §222(b)(2). [3] IRC § 222(b)(2). [4] IRC § 222(d)(1). [5] IRC § 222(d)(1). [6] IRC § 222(d)(1).

34. [1] IRC § 408A(c)(3)(C). [2] IRC §§ 408A(c)(2), 219(b)(5). [3] IRC § 408A(c)(3)(C)(ii). [4] IRC §§ 72(t)(2)(E), (7). [5] IRC §§ 72(t)(2)(E), (7). Note that IRC § 408A does not mention “qualified higher education expenses. IRC § 72(t) provides an exclusion from the 10 percent additional tax imposed on early distribution from any IRA (not just Roth) to the extent used for qualified higher education expenses. [6] IRC §§ 72(t)(2)(E), (7).

35. [1] IRC §§ 529(c)(3)(C), (5)(B). [2] IRC § 529(e)(3). [3] IRC §§ 529(e)(5).

36. [1] IRC §§ 530(b)(1)(A), 530(c). [2] IRC § 530(c). [3] IRC § 530(d)(6). [4] IRC § 530(b)(1)(A)(ii). [5] IRC § 530(b)(2)(A). [6] IRC §§ 530(b)(3),(4)(B).

37. Compliance – Returns Received 37